Enhancing insurer value through reinsurance optimization

Abstract

The paper investigates the demand for reinsurance in insurer risk management. The insurer’s objective is to maximize shareholder value under a solvency constraint imposed by a regulatory authority. In a one period model of a regulated market where the required solvency level is fixed, an insurer is assumed to maintain solvency using two control variables: reinsurance and risk capital supplied by shareholders. Two alternative regulatory constraints are considered in the paper. In the first one the required risk capital is determined at the beginning of the period independently of the reinsurance decision. In the second model insurers can reduce the required minimal level of risk capital taking into account reinsurance. The first model does not create a demand for reinsurance in a frictionless market, however, there is demand for reinsurance in this model under the presence of corporate tax and financial distress costs. An optimal tradeoff between the required minimal level of the risk capital and purchase of reinsurance occurs in the second model. The impact of taxation and financial distress costs on the demand for reinsurance is quantified and assessed using the models.